Underwriting Commercial Real Estate Loans

I'm starting a new job where my first project will involve risk modeling for commercial real estate loans. What do those of you in the business look at when you underwrite these things, and why? What are the major risks to consider?

Generally, you look at three risk metrics and underwrite the loan size to the lowest of the three. For example, you have a $50MM property and want to make a loan, you require a max LTV of 65%, a min DSCR of 1.2x, and min debt yield of 8%. The property's NOI is $2.5MM, interest on the loan is 5%, and the loan term is 30-years

Therefore, underwritten loan amount would be $31.25MM. The reason that you look at LTV is pretty straightforward - the higher the LTV, the greater the lender's exposure to cap-rate expansion, reductions in NOI via poor management or increased vacancy, making it less likely that they can be re-financed out or have the property sell at a price that allows the borrower to repay them. DSCR is also fairly straightforward and just shows by what margin the borrower can cover debt service. Debt yield is essentially a lender's cap-rate (unlevered yield) and, to its benefit, ignores external factors such as changes in interest rates (think floating rate loans), swings in multiples, and loan term.

Obviously, this ignores any qualitative assessments of risk, but that doesn't seem to be what your'e asking about.

I come from down in the Valley, where Mr. when you're young, they bring you up to do like your daddy done.

Historic occupancy, any downward trend over historical income, or any upward trend over historical operations. Basically and trend can be a risk, but even more than that, borrowers experience, specific markets, and concessions can also be at the forefront. For example, the last thing i want to see when I'm looking at a loan request is concessions numbers through the roof over the past 6 months. We always ask the borrowers what their concessions burn off plan is, and they constantly say "2-3 months we'll be 0's on concessions." Rarely the case, and a simple call to the property can confirm that concessions are likely to still be around after that time frame.

above all, you want to make sure that the current or future cash flows you are modeling value off of is supportable in the market. You can and will hear it differently from many in the industry, but from a risk standpoint, historical operations are always the best indication of future performance. If you want to mitigate risk, go off what historical performance.

Underwriting debt is very easy. As mentioned above, cash flow is king. Lenders primarily size their loans based on LTV and DSCR. LTV is based on how much risk the bank is willing to take. DSCR is the most important. The lender will use past NOI from last few years. They will also create a risk model showing a decline in NOI for their credit committee.

My group does have some differences in metrics for different property types, but the differences aren't huge. Multifamily can generally have slightly higher leverage. Retail generally has more stringent requirements

In general, most require a minimum of 1.20-1.30x DSCR, a maximum of LTV and LTC around 70-80%. I typically see that the most common constraint is DSCR with most deals panning out in the 50-70% LTV and LTC range.

I work in CMBS and we use different minimum requirements. Multi/Industrial/Office/Retail, we use a minimum of 1.25x, 8%, 75%. Hotels we use 1.4x, 10%, 65%.

The criteria is also sometimes dictated by our B buyers, one of our B buyers will not buy any student housing with a less than 10% DY. So we just dont look at deals and ask whether it's good real estate or a good deal, we ask ourselves how would rating agencies or B buyers treat this deal. I imagine the balance sheet lenders will be wondering how would their credit team look at this deal, so there so much more than just the minimum requirements. Those are pretty easy to meet.

In my view, fixed or floating rate, debt yield would have to be considered. dscr can be easily manipulated to squeeze a deal into meeting your minimum requirements- you can increase IO, reduce rate, increase amort. But all that only increases risk for the lender. The whole purpose of dscr is measuring probability of default and manipulating it and increasing risk is just defeating its whole purpose. But the rate, amort, IO makes no impact on debt yield. Its strictly NOI in relation to loan amount. For a $1MM property would you want $100K or 50K in loan amount? I would want 100K. And then as the next step I start to investigate the location of the property, product type, sponsor etc.

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